If I could name the single biggest mistake my customers make with respect to inventory management, it would have to be their assumption that low inventory levels mean low costs. Where they see low costs, I see a disaster waiting to happen. Where they see low costs through low inventory counts, I see a company suddenly paying expedite fees to rush parts in to meet customer demand. Where they see low inventory costs, I see high per-unit freight costs on rush shipments of parts and materials. Where they see low inventory costs, I see material shortages and possible machine downtime in manufacturing. What they don’t see, I see all the time.
Low Inventory Counts Rarely, If Ever, Means Low Costs
It’s important to do away with the misconception that low inventory means low costs. It’s fairly obvious that the aforementioned outcomes help to dispel this myth, but the question that often arises is why some companies aren’t unable to see these costs themselves. Are they running a tight inventory due to cash flow? Is it because of the fear of having too much inventory and encountering damage and obsolescence? Is it because of the high costs of inventory financing? Or, is it merely because the company hasn’t properly defined its inventory costs and therefore, doesn’t have the means to track these costs? A number of companies concentrate solely on their costs of holding inventory without sales, while ignoring their costs of lost sales due to low inventory counts. Ultimately, it means the company isn't properly assessing its true costs of managing inventory.
Of all the issues I’ve encountered as to why companies ignore these costs, it’s this last one that is almost always the main culprit. Unfortunately, most companies lack the ability to track these costs back to their source because they have not properly defined their costs of inventory. These costs are defined as one of two outcomes. The first is high carrying charges due to high inventory matched to low demand. The second is lost sales which is defined by low inventory counts during high demand.
In the end, ignoring both of these cost drivers means a company will invariably encounter the following costs with respect to how they manage their supply chain.
- High freight costs for urgent shipments from vendors.
- High expedite fees for urgent orders from vendors.
- Impact of "OOS" (out-of-stock), lost sales and material shortages.
- High freight costs to rush finished goods out to customers due to being late on delivery.
Most companies chalk up these aforementioned costs up to their “costs of doing business”. Rarely do they attribute these costs to how they run their inventory. If they lose sales due to low inventory counts, they don’t attribute those lost sales to managing inventory.
If they have high freight costs for incoming shipments, they don’t attribute those costs to maintaining too low an inventory count. Instead, they simply rationalize these costs as those pertaining to their business cycles or fluctuating customer demand. If there’s one thing you must take from this post, it’s that low inventory rarely ever means low costs. In fact, in a large number of instances, it means the exact opposite!
The graph above is a depiction of lost sales cost of inventory due to low inventory counts. it is from the post: Supply Chain Management: When Inventory Doesn’t Match Customer Demand
Define Your Inventory Costs First and Then Track Costs
In order to get a greater appreciation of your company’s inventory holding costs, I’ve included the table below. It’s from the post, Sample Excel Sheet Calculating Inventory Holding Costs. The post allows you to define your company's unique inventory carrying costs. Next, you then use those monthly carrying costs to define your company's costs of holding finished goods without sufficient sales.
Most of my customers are shocked to see just how much their inventory costs them. Instead of defining these costs and tracking their impact, they allocate these costs into various categories. For instance, some don’t properly track their per-unit freight costs on incoming parts and raw materials. Instead, they put it in a “freight bucket” of some kind – as if it had nothing to do with inventory. Most of my customers ignore the high costs of lost sales due to low inventory counts. Instead of giving their inventory managers gross profit objectives, they rationalize that it’s always the fault of the sales department for poor sales forecasting. While sales does play a role in a company’s inventory levels, it’s simply wrong to assume that it’s always the result of the sales department not properly forecasting sales.
If you’re looking for a way to bridge the gap between your sales and inventory management department, then please read the following two posts:
Small Business Inventory Asset Management: Using an Inventory Analyst
Comments